The Stock Market And Recessions

Mike Patton
, ContributorI provide analysis on the economy, investing and financial planning.Opinions expressed by Forbes Contributors are their own.

Is the U.S. headed into another recession? Although a good argument can be made on either side of the issue, it's important to understand how stocks perform just prior to, during, and toward the end of a recession. To analyze this, we'll examine the period from October 1928 to the present.

During this 84 year stretch, there were 14 economic downturns in our economy. Actually, one of the 14 was a depression, but still, these periods indicated a contraction in economic activity. There is some discussion as to what constitutes a recession. Some define it as a prolonged period of economic contraction. Others define a recession as two calendar quarters with negative GDP. Whatever your preference, a recession is not good for business. In short, it is a time when most businesses cut back and make preparations to ride out the storm. Before we examine stock market performance during recessions, let's take a quick look at our economy today.

We have just completed our 42nd month of unemployment above 8.0%. Actually it's risen to 8.3%. This is a clear signal that businesses are reluctant to hire in large enough numbers to bring down this all-important number. Another very important statistic is the Purchasing Managers Index or PMI. PMI measures the economic health of the manufacturing sector. A reading below 50 is an indication of economic contraction. In June it fell to 49.7. However, it has risen since then and today stands at 51.9. Still, this is a signal of a weak economy.

The U.S. is the largest economy on Earth by a wide margin. However, with Europe heading into recession, China slowing, and Japan, well, poor Japan, it will be difficult for America's economy to run on all cylinders when the global economy is screeching to a halt. Now, as promised, let's get to the stock market.

Economic contractions (i.e.recessions) are not good for the stock market. When the velocity of money decreases (spending declines), profits are squeezed, and since companies rely heavily on profits, stock prices suffer. Frequently, stocks begin their descent just prior to, or as a recession begins. Then, sometime during the recession, stocks usually begin to rebound. The severity of a recession and the unemployment rate are also mitigating factors.

It has been said that a picture speaks a thousand words. Below is a series of four charts which illustrate the performance of the DJIA (blue line), recessions (shaded in grey), the volume of trading (in red) and statistics on each recession/depression. Take special note of the movement of stocks as they react to the effects of these recessions.

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Where do we go from here? If I had to say, I believe there is a better than average chance that the U.S. will enter another recession in the near term. Therefore, I wouldn't be raising my stock exposure just yet.